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While most organizations have a financial or accounts department, it often strikes me that this department is limited to doing just that – accounting. Financial management however, is more than accounting; it provides analytical reports that inform management on the financial position of the company. The annual report of the company will include financial statements and management needs to find out what these statements say about the company. Let us refresh our minds and look at some of the basics of accounting.
Essentially, accounting is the process of measuring and reporting an enterprise’s assets and liabilities. The difference between the two gives the owner’s equity; Equity = Assets – Liabilities.
Assets are defined as an enterprise’s economic resources. However, in accounting, there are restraints on reporting their value. A business can report an asset only when it exists. For example, a company that signs a contract to construct a building can include the assets arising under that contract in its financial statements only when the work is done. Also, if somebody has taken a mortgage to buy a house, that house will only become an asset when the mortgage has been paid. Until then the house is that person’s liability and the bank’s asset. Most assets are recorded at their purchase price until there is evidence that prove that the value has changed.
Liabilities are present obligations either to convey assets or to render services to someone in the future as a result of past transactions. Most liabilities are payable in cash. The value of many liabilities can only be estimated. For example, consider the liabilities of an insurance company for claims that have not yet been reported. Liabilities that will be satisfied by providing services like rents, subscriptions and ticket sales received in advance, are easy to measure,. The prices of these liabilities have been established and either they have been performed or they have not – but, the liability exists only for unperformed services.
The owner’s equity is the excess of assets over liabilities and therefore depends on how assets and liabilities are measured. A financial report includes three major financial statements plus additional disclosures necessary for completeness. These disclosures are often called “footnotes” but they are accurately described as “notes to the financial statements”. The three major financial statements are the fol lowing. Balance sheet cashflows, Income statement, also called the profit & loss statement or earnings statement, and Statement of cash flows. Most corporate financial statements include an additional report on changes in shareholders’ equity.
The balance sheet is a listing of, on one side, all the enterprises’ assets and on the other side, the enterprises’ liabilities plus the owners’ equity. The assets are organized according to their tendency to be liquified. The first category includes current assets, which comprises cash and assets that will be turned into cash (such as stock and debtors) within one year or the current operating cycle of the enterprise which could run longer than a year. Other categories include the long term tangible assets, investments and intangible assets such as copy rights, patents and goodwill. There can also be a category called other assets, for assets that managers are unable or unwilling to categorise.
Liabilities are classified between current liabilities, those payable within the period used to define current assets, and all other liabilities known as non-current liabilities such as long term debts.
For corporate enterprises, shareholders’ equity is classified into paid-in capital the amounts received as investments by the owners, retained earnings – the cumulative amount of earnings reinvested in the company, and treasury stock – a deduction for the cumulative amount paid by the company to buy back its shares.
The income statement and cash flows are more dynamic than the balace sheet’s static nature. While the balance sheet tells us where we are, the income statement and cash flow statement show us how we arrived there. They cover the period between two balance sheets. The income statement lists first the revenues of the company. Revenues are the gross increase in company value from selling goods and services to customers. Expenses, costs incurred to earn the revenues, are deducted from the revenues to obtain the profit or income. Expenses make up the gross decrease in company value from the production and delivery of goods and services to customers.
The statement of cash flows presents gross cash flows, positive and negative cashflows -which are classified as operating cash flows, investing cash flows and financial cash flows. Operating cash flows are the flows relating to income statement items such as collections from customers, payments to suppliers, employees, utilities, etc. Investing cash flows are the payments and receipts from buying and selling assets, buying other businesses, etc. Financing cash flows comprise the transactions by which the enterprise raises capital, including borrowing, debt repayments, dividend payments, proceeds from issuing share capital and amounts paid to buy back shares.
Using the above mentioned financial statements, comparisons can be made over time. Changes reported over a given period will provide useful information about the enterprise because each operating cycle’s statements have been prepared in a comparable way.
From: Mastering Management 2.0 – “How to read those financial reports” by Peter Knutson